The Erosion of Best Buy's Economic Moat

At first glance,  Best Buy (BBY) would appear to be in an enviable position relative to its retail peers. Chief rival Circuit City and several other industry participants have vacated the space, leaving more than $10 billion in industry sales up for grabs. Efforts to expand its footprint in Canada and China have been successful, and the recent partnership with Carphone Warehouse in Europe should allow the firm to tap a larger percentage of the $700 billion global consumer electronics marketplace. And with Geek Squad, Best Buy has one of the most widely recognized technical support and installation service operations among consumer electronics retailers. So why did we lower the firm's economic moat rating?

The answer is not a simple one. It boils down to several factors, including increased competition and a possible inflection point in the traditional consumer electronics distribution model. During the last five years, mass merchants and consumer electronics vendors themselves have taken aggressive steps to capture incremental market share, likely eroding the power Best Buy once had over its suppliers. Moreover, as consumers increasingly embrace digital distribution, we believe that several of the firm's competitive advantages--including a well-known brand name and prime retail locations--may diminish. Although we anticipate incremental market share gains over the short run stemming from the recent shakeout among consumer electronics retailers, we believe Best Buy's market share will wane over an extended period of time.

The Looming Threat of Competition
Due to constant technological innovation and rapid speeds to product commoditization, consumer electronics shoppers tend to have little, if any, switching costs. Products like flat-panel televisions, DVD players, and digital cameras are differentiated largely by price, with consumers tending to be more brand-loyal than channel-loyal. This has given the upper hand to industry behemoths that have a reputation for low prices like  Wal-Mart (WMT),  Target (TGT), and  Costco (COST) and well-known online retailers such as  Amazon (AMZN) (which does not charge sales tax). With significant market share up for grabs, we anticipate that competition from mass merchants, warehouse clubs, and online retailers will only intensify in the coming years. In our view, this competition will change the economics of the consumer electronics category--likely dragging down Best Buy's returns on invested capital in the process.

In our view, a reputation for having more competitive prices has spurred market share gains for mass merchants and warehouse clubs. According to our estimates, Best Buy was the largest consumer electronics retailer in 2008 (with about 18% of the $179 billion domestic market, using data from the Consumer Electronics Association), followed by Wal-Mart (11%) and the now-defunct Circuit City (6%). However, Best Buy's market share has remained relatively stable during the last five years while Wal-Mart, Target, and Costco have each made up ground. If mass merchants and warehouse clubs were able to capture market share during the advanced television product cycle that drove industry sales during the last five years, we question whether Best Buy possesses enough of a competitive advantage to defend its market share over an extended horizon.

Our primary concern regarding mass channel competition is that Best Buy may need to resort to increased promotional activity to stay competitive. We have witnessed a number of examples of promotional activity from Best Buy during the last year--including free delivery and installation for flat-panel TV purchases and no-interest financing offers--and we do not believe these were entirely the result of the current economic downturn. Even though some promotions will be supported by vendor financing, we expect more aggressive industry pricing over the coming years, likely keeping Best Buy's profits in check.

Potential Shift in Electronics Distribution
In addition to more aggressive mass channel competition, we also expect more consumer electronics vendors to follow  Apple's (AAPL) lead and develop their own retail distribution channels. By using their own retail channel, consumer electronics manufacturers can showcase products in a noncompetitive retail environment and foster greater brand loyalty. If this movement gains enough steam, consumer electronics manufacturers would have much less dependence on the specialty retail channel, thereby weakening the power Best Buy has over its suppliers.

This movement also underscores our concern with growth plans for the Best Buy Mobile concept. During the next several years, we expect wireless carriers-- AT&T (T) and  Verizon Communications (VZ), in particular--to more aggressively move into the retail channel and reduce their dependence on third-party specialty retailers, likely resulting in diminishing returns on invested capital for Best Buy Mobile. We also view the increasing number of wireless kiosks at warehouse clubs and lower-priced wireless alternatives as competitive threats.

 

Threat of Digital Distribution
We also have questions about how Best Buy will address the increasing prevalence of digital distribution. Generally speaking, we believe that the digital distribution model provides several advantages for entertainment content providers--including direct access to consumers, better control over distribution, and reduced threat of used software sales (where publishers receive no proceeds)--and it is only a matter of time before digital distribution gains mainstream acceptance.

Although we are intrigued by Best Buy's recent digital distribution partnership with Sonic Solutions , where the firm will license and deploy Sonic's Roxio CinemaNow on-demand digital video content platform in a number of consumer electronics products, we also have some concerns. First and foremost, we are not sure that the partnership will be significant enough to displace better-established competitors such as Apple's iTunes,  Netflix (NFLX), or cable providers. Second, Best Buy does not manufacture the products that will use the CinemaNow platform, so the partnership depends on vendors to develop compatible devices. Finally, we view this announcement as another signal that Best Buy's in-store entertainment software assortment will continue to shrink during the next several years.

Best Buy's store layout has already begun to evolve as a result of digital distribution, in our view. During the last few years, a portion of the floor space previously devoted to entertainment software, such as CDs, DVDs, and video games, has already been shifted to mobile phones and digital cameras. Most stores also feature video-game play stations, where consumers can test video game peripheral devices before purchasing. The firm also recently added a "Gadgets and eReaders" collection, featuring more than 120 different products.

However, as digital distribution gains steam, we have concerns about the continued shrinkage of the entertainment software category, and more importantly, what its replacement is. Due to rapid technological advances, the answer is not an easy one. We suspect that there will be an increase in the square footage devoted to higher-end appliances and a more substantive used video-game platform, much like the program that was recently introduced in Best Buy Canada stores. We also expect additional space will be devoted to digital cameras and mobile phones, as well as more gadgetlike products, such as digital photo frames.

Unfortunately, we believe that this transition will also have a dilutive impact on sales and profitability, which we have accounted for in our valuation assumptions during the next decade. Entertainment software products typically carry higher gross margins (approximately 30%-35%) than consumer electronics or appliances (usually between 15% and 25%, depending on the category). Although we expect operating margins to rebound from the 4.2% posted in 2008, we believe the firm may struggle to get back above the 5% threshold without more drastic changes in its business model.

Services Provide Advantage but Can Be Replicated
Given the challenges we have outlined above, we believe Best Buy is prudently taking steps to differentiate its retail experience. Through store formats that are customized for local consumer preferences, in-store Geek Squad technical support services, and high-end Magnolia home theater departments, Best Buy provides a shopping experience that mass merchants and warehouse clubs cannot presently match. The firm has also expanded its at-home technical support and installation services, a segment that could gradually develop into a multibillion revenue stream, in our view.

However, we do not believe Best Buy's service offerings provide enough of a competitive advantage to fend off rapidly encroaching rivals--a change from our previous thesis. Because consumer electronics are often commoditized products, we believe that consumers naturally gravitate toward the lowest prices when making consumer electronics purchases, all things being equal. We believe that more competitive pricing from mass channel rivals played a role in the bankruptcy of several smaller consumer electronics retailers during the last decade--several of which also touted installation, maintenance, and technical support services as a point of differentiation. As a result, we are not sure that service offerings provide enough incentive for consumers to pay premium prices.

Although we consider Best Buy to have the most-developed technical support and installation offerings among any consumer electronics retailer, the segment represented only 6% of the firm's domestic sales during 2008. Furthermore, we also have concerns that consumer electronics services could ultimately be replicated by the mass channel. Given the market share that they have amassed during the last five years, most mass merchants have already introduced some form of consumer electronics services, including Wal-Mart's recent partnership with privately held N.E.W. Customer Service Companies to provide technical support. We believe Best Buy will face increased competition from new services entrants during the next several years, keeping growth to a relatively modest pace.

Don't Be Fooled by Short-Term Improvements
Although we removed Best Buy's economic moat rating because of evolving industry dynamics, we still believe the firm possesses several competitive strengths and will gain market share from former Circuit City shoppers over the short run. We also find the firm's international growth prospects compelling, especially as Best Buy further develops its Carphone Warehouse partnership. As such, we believe there is a strong likelihood that the firm's fundamentals will rebound sharply during the next year or so, especially if consumer sentiment and discretionary spending trends continue to stabilize. However, our concerns are longer-term in nature, as history has shown that consumer electronics retailers that offer the most competitive price tend to thrive, while those that don't usually lose ground.